Dispatch€s from Frankfurt: July is off, September is on
But don't expect guidance next week
A July rate cut never looked very likely, but a September reduction is now my central case. Data has been more benign, vindicating the June move, downside risks have intensified, and Sintra suggests the ECB’s risk management posture is tilting more dovish in the near term. That said, there is not likely to be guidance for September. For next year and beyond, worker bargaining strength will be important for the floor in interest rates.
September cut is coming
I’ve changed my mind on September – a rate cut is now my central case (again).
Vindication of June cut. I don’t normally like looking in the rear-view mirror, but in this case it helps to understand where we stand.
In my opinion, the governing council had painted themselves into a corner by very early on essentially pre-committing to a June cut (did I mention that the ECB should resist the forward guidance temptation?). Having done so, the council had to deliver the cut at a time when the data (and the staff forecasts) wobbled, actually lowering their confidence in inflation returning to target.
As a result, the communication in the June meeting was awkward: they had to convey increased confidence to justify executing on the cut, all the while the staff projections and the overall rhetoric conveyed decreased confidence.
Since then, a lot has happened.
In my view, the data has ex post vindicated the rate cut – and then some.
June inflation was more benign, and Q1 national accounts data showed profits receding sufficiently to allow (deflator) inflation to decline despite still sturdy wage growth. June PMIs and the ifo suffered a setback.
Intensification of downside risks to growth. And then there were events.
While a great deal of uncertainty remains, the “hawkish” scenario for ECB rates from France of a sizable fiscal expansion is receding, as RN is not likely to govern and NFP is not likely to govern alone.
This leaves the negative uncertainty shock from the election that I had flagged previously. While more adverse scenarios have been averted, there remains the worry of political paralysis which may still affect (corporate and consumer) sentiment in the short term.
Last but not least, even if an issue for January and beyond, following Biden’s debate debacle the spectre of Trump 2.0 looms large over Europe.
While not all of the risks out there are immediate, or necessarily disinflationary – some may be stagflationary – my overall sense is that cumulative effect on the ECB is dovish near term. At least that is the overall sense that I got out of Sintra.
Sintra: shift in the ECB’s reaction function. My one-sentence summary of Sintra would be this: The intensification of downside risks to growth now tips the scales of its risk management approach in a more dovish direction.
Many people’s takeaway from Sintra was focused on what it meant about the July meeting.
And indeed, President Lagarde essentially ruled out an interest rate cut next week (“it will take time for us to gather sufficient data to be certain that the risks of above-target inflation have passed”).
To me, July was never very likely and was effectively ruled out at the latest with Isabel Schnabel’s interview already in May. Instead, what stood out to me was
the latter half of the above sentence, because it states explicitly that the ECB now sees above-target inflation as a mere residual risk – residual, because waiting for the data is now about acquiring certainty.
there was explicit reference in the President’s speech to a soft landing being desired (“Given the magnitude of the shock to inflation, a “soft landing” is still not guaranteed.”)
the ECB is now more alert to downside risks, and sees limits to waiting. “The strong labour market means that we can take time to gather new information [NB: channeling the Fed], but we also need to be mindful of the fact that the growth outlook remains uncertain.” The first part of the sentence says that while there is no big hurry, the general posture is to lower rates. The second part is interesting in that (i) it’s a juxtaposition with the first part, so it’s about the limits to waiting to gather new information, and hence (ii) the uncertainty is a reference to downside risks to growth more than two-tailed risks.
Don’t mention the Fed. For what it’s worth, I have always been skeptical about the ECB’s degree of dependence on the Fed at times when inflation is mostly generated by domestic factors – namely services and wages.
Nonetheless, the hawks have used exchange rate depreciation as an argument to push back against (too many) cuts. With the June US CPI data materially affecting market expectations of a September Fed cut, the hawks may end up being deprived of this argument (even if the September Fed meeting is a week after the ECB one).
In short: unless the data between now and September – and as a result the September staff projections – show significant reasons to cast doubt on the trajectory of inflation converging to target by 2H next year, a rate cut is likely, in my view (followed by another one in December).
Just don’t expect pre-commitment
That being said, I see little chance of pre-commitment next week similar to the one ahead of the June meeting.
Lessons learned. Even before the June meeting, some governing council members’ comments suggested a certain degree of “buyers’ remorse” on having pre-committed.
Low visibility. The post-election French political and fiscal trajectory remains unclear, even if scenarios of large fiscal expansion seem to have been averted. The data remains noisy – the June Indeed wage growth data being a case in point (a case of more noise than signal, in my view, see the chart below). Moreover, it’s unclear how persistent the uncertainty shock will be in France, and the Olympics could blur the picture, potentially making both July and August French business surveys (and inflation data!) difficult to interpret.
Source: Macrobond, Eurostat, Indeed
In short: I’d expect an affirmation of the easing bias – as in Sintra – but vagueness on September, as befits a more genuine data dependent approach.
Keep in mind workers’ bargaining strength
When looking beyond the end of the year, however, low frequency wage dynamics will remain important.
The tightness of the labor market looks like it’s here to stay, certainly if a cyclical recovery stays on track. That, in turn, strengthens workers’ bargaining position, helping them secure a larger slice of the pie: the share of wages in GDP is likely to remain elevated (see chart below).
This is likely to limit the space for ECB cuts in this cycle. I stick to my 2.75% expectation for end-25.
